The Week In Review – Global Equities

Pretty lackluster YTD performance

Traditional low beta sectors such as Staples, Telecom and Utilities continue to under-perform
Tech keeps impressing with not end in sight for large cap growth darlings
Energy stocks continue to benefit from rising crude prices

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Eric J. Weigel

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Key Asset Allocation Insights – Weekly Review

The Week In Review

Asset allocation strategies came under attack last week as global capital markets saw the period of extreme calm come to an end
Between the “memo”, earnings week and Super Bowl preparations there was a lot going on
None of the key asset classes that we use in our asset allocation process escaped the increase in investor risk aversion. Volatility really spiked up on Friday
The Fed did not hike rates at Janet Yellen’s last meeting as Chair but did raise the specter of inflation
We have been in the camp that believes that investors have been underpricing inflation risk
Three huge US companies (JP Morgan, Berkshire Hathaway, and Amazon) are planning to launch their own health care network. Nobody has found the cost-containment magic. Maybe self-insuring and pooling “healthy” employees is the way to go

Key Asset Classes:

Last week saw the best performing asset classes of last year take the biggest hit

Asset classes across the board suffered losses. Diversification only lessened the blow

Emerging markets still remain in an UP TREND but profit-taking may have set in

Interest sensitive asset classes are firmly entrenched in Down Trends

Currencies:

The USD keeps depreciating and the Trump administration seems to favor this trend

A weak USD should provide a boost to commodity prices

A weak USD also makes imports more expensive further boosting inflationary pressures

In my view, USD depreciation is a function of political turmoil in DC

Higher short-term rates in the US provide a floor to the USD – don’t expect massive USD depreciation

Commodities:

In a week where news outlets told us that investors once again became fearful of inflationary pressures, commodities did not fare well

I am a bit skeptical that the reason the equity market got clobbered was a realization that inflation was a problem

I still think that inflation risk is underpriced by investors, but the stress in the equity market seems unrelated to commodity prices

Investor Risk Aversion:

Our most recent Risk Aversion Index reading returned to the Normal Zone

On a 4 week moving average basis, the reading is still in the Euphoria Zone

Prior weeks readings have been extraordinarily low indicting great investor complacency

We expect a risk on/off market in 2018 – Friday might have been the start of more normal risk levels

Chart of the Week:

Inflationary expectations are ratcheting up

Wage growth is the most cited reason, followed by a strong US economy

A weak USD is also at work

What We See This Week:

A bit more fear – I see a lot more risk on/off in 2018
Further profit taking – I think that investors know that 2017 was a gift from above
Taking some money off the table may be a smart move especially given valuation levels
The money is likely to be deployed in cash, not bonds
Continued distaste for bonds as an asset class
Some recovery among healthcare stocks in the US – the JP Morgan, Berkshire Hathaway and Amazon venture will take time to crystallize
Lots of earnings – big companies reporting( Disney, Gilead, Tesla, Mondelez, GM, Allergan, Humana, Prudential, Cerner, Cummings, …)

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

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DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Is Hope The Only Active Strategy Left?

There are so many stories going on in the press about the demise of the active management industry that one gets the impression that every portfolio manager must be feeling like a gambler pawning his last possession.

I recently attended a wealth management forum put together by Marketwatch were the commonly held view among attendees and panelists was that active management is dead and that the whole investment industry has been commoditized.

Certainly when evaluating security selection strategies relative to passively constructed benchmarks the recent record of active management leaves a lot to be desired. Times have been tough for active management shops and investors have been flocking to a myriad of index strategies. Exchange-traded funds (ETF) and multi-asset class strategies such as Target Date Funds have been the primary beneficiaries.

Barron’s magazine recently reported that only 33 percent of active equity managers managed to beat their benchmark last year. Outflows from actively managed strategies surpassed $288 billion (through November) – worse even than for 2008.

The popular S&P SPIVA report shows that the situation is not any better if one looks at a longer time period. For example, as of June of 2016, only 8 percent of US large cap strategies managed to beat the S&P 500 index over the trailing five years.

Midcap and small cap managers did not fare any differently. How about REIT managers? Not really – only about 11 percent of active strategies beat their index over the last five years.

International equity managers did fare a bit better than their US counterparts with close to 40 percent beating their index over the last five years. 32 percent of emerging market equity managers likewise beat their benchmark. A bit more hopeful but still nothing to write home about!

What about fixed income active strategies? A bit better in smaller pockets of the markets such as municipals, short and intermediate term investment grade where the majority of funds had higher returns than their corresponding index.

But among longer maturity strategies the situation was as abysmal as for equity managers. For example, only 3.5% of Long Government strategies outperformed over the trailing five years. Even in the emerging market debt category only 8 percent of active strategies outperformed.

Is hope the only strategy left for the active investor? Just like the gambler down to his last pennies it sure feels lonely out there. All active management friends seemed to have slithered out the back door.

If the data cannot be tortured to confess, what about using theory to defend active management? Unfortunately, little help seems to be coming from the halls of academia. Many years ago Bill Sharpe published his famous paper on “The Arithmetic of Active Management”. The basic idea that active managers bear higher costs than passive investors thus creating a wedge in performance between the two has stuck as a reasonable theoretical explanation for the under-performance of active management.

Recently, there has been some debate about some of the logic used by Sharpe (see the recent Lasse Pedersen paper) but in general while it is clear that index funds are not totally passive (due to new issues, repurchases, and index membership changes) the consensus still seems to be that the basic disadvantage of active management is due to its higher costs.

Another argument working against active management was espoused by another Nobel Prize winner Paul Samuelson even longer ago. Samuelson held that the stock market is micro-efficient, but macro-inefficient.

What this means is that at the level of individual stocks (where active managers ply their trade) it is much harder to beat the overall market but that the market itself may occasionally exhibit economically significant deviations from fundamental value. Research by Jung and Shiller at Yale corroborates the Samuelson story of micro-efficiency and macro-inefficiency.

Every active manager knows that outperforming benchmarks is tough especially in a consistent manner. A quote by Charlie Ellis of Greenwich Associates has stuck with me over the years. While I can’t remember the exact wording it goes something like this – “outperforming is difficult not because investors are stupid but because they are smart and compete with each other”.

I might have butchered Charlie’s quote but the basic idea is that with so many smart people participating in the markets today active management has become at least conceptually a zero sum game with the additional handicap of higher costs.

What this means is that on a capital weighted basis for every winner there must be a loser (assuming a fairly static market portfolio) but both must bear the burden of higher costs. These costs are especially detrimental in an environment of lower capital market returns such as the one currently anticipated by Global Focus Capital.

Given all the evidence against active management what is the investor to do? Load up on ETF’s and run away from actively managed strategies? The flow of funds data certainly seems to be confirming this behavior. Active equity and bond managers have seen massive outflows to their strategies while flows to ETF’s have grown consistently for over ten years.

Sincerely,

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERROR

Halloween Is Not Just For Children – Time For Some Tax Loss Harvesting!

At this time of the year people living in the Northern Hemisphere are starting to prep their gardens for winter and if you live in the countryside many people are harvesting their summer crops.

In New England as the days get shorter and the temperatures drop families with young children will often visit one of their local farms and pick their own pumpkins for Halloween.
Just writing this brings back great memories of my children when they were young, but there also a different type of harvest that those of us near or in retirement should take part in – definitely not as fun but maybe of lasting value.

What I am referring to is tax loss harvesting. Uh, ah I just filed my taxes for last year and now you want me to focus on the dreaded “t” word again? Please allow me to explain. In my life travels I have never met anybody that does not think that they are paying too much in taxes and would love to lower their annual contribution to the government coffers (in a legal way of course).

One way of doing this which is pretty straightforward but often ignored is tax loss harvesting. Along with enjoying harvesting pumpkins with your children or grandchildren why not harvest your investment losses as well?

After all as we have shown in earlier writings (Leaving Money On The Table) proper tax management of investment portfolios can dramatically alter financial outcomes especially over long periods of time.

How does tax loss harvesting work? Tax loss harvesting is an approach to minimizing how much you pay to the government on the (hopefully) gains in your investment portfolio. What it involves is selling those investments where things did not pan out as expected and you incurred losses. You would then offset these losses with the gains that you hopefully have on other investments. A good background read on tax loss harvesting prepared by Fidelity Investments can be found here.

While everybody’s circumstances are different let us look at a simple example. Let’s say that at the beginning of the year the Mitchell’s bought a portfolio of Health Care stocks that unfortunately lost 20% of its value resulting in a loss of $10,000. They also luckily bought some energy stocks In January that currently exhibits $15,000 worth of gains.

The Mitchell’s are now worried about all the negative publicity surrounding oil surpluses and wish to sell their energy holdings. Doing so would trigger short-term capital gains on which they would have to pay taxes. On the other hand the Mitchell’s think that Health Care stocks will soon rebound after the US Presidential Elections turning their current paper losses into winnings.

But just like things do not always work out as expected, tax issues are never straight forward so in order to lower their overall tax bill they would have to sell both their health care and energy investments. Not really what they wanted to do, but a lower tax bill this year would come in handy to pay for that winter getaway vacation to Costa Rica.

However, what the Mitchell’s can do is go ahead with both sales, legally offset gains with losses and then buy an essentially “similar” investment in health care stocks. For example if they previously owned a basket of Pfizer, Mylan and Bristol Myers stock which they must now sell they could buy the S&P 500 Health Care Exchange Traded Fund (ticker XLV) as a replacement. From an IRS perspective that is a permissible transaction. So essentially they have maintained the same exposure to health care stocks but lowered their tax bill.

Assuming that the Mitchell’s are in the 25% marginal tax bracket they would owe $1,250 to the tax authorities using tax loss harvesting as opposed to owing $3,750 if they had sold their energy holdings and held on to the losing position in health care stocks. And their portfolio is still essentially positioned as they want with a bet that health care stocks will rebound post-election. They just turned lemons into lemonade and are able to save $2,500 in taxes which they can use to travel to their favorite winter spot on Tamarindo Beach in Costa Rica!

Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy

Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant part of the potential tax alpha on the table.

Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more advanced applications encompass security positions across different asset classes.

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

That Free Rebalancing Dessert Can be Costly!

Rebalancing is a topic held near and dear to the heart of many investment advisors and often forms a key building block of what the advisor perceives as his or held value add. If diversification is viewed as a free lunch then rebalancing is often viewed as free dessert.

Unfortunately while the benefits of true diversification stand the test of time the same cannot be said about rebalancing especially when done in a highly automated way such as frequently seen in many robo-advisor offerings.

What do we mean by rebalancing? There are many reasons why investment advisors intentionally shift the weights of their portfolio components over time. The manager may have a changed view on future expected returns or they may deem a certain investment to now possess an unacceptable level of risk and thus wish to cut back on the exposure. Others may wish to more closely track a commercial index and do a wholesale portfolio rebalance to minimize deviations from benchmark weights.

In general there are two basic underlying motivations for rebalancing. The first is informational – the weighting structure of the portfolio is consciously changed to reflect an updated perspective on forward-looking estimates of return and/or risk.

The second basic motivation for rebalancing is purely driven by an automated rule that is agnostic to changing views on capital market risk and return conditions. The rebalancing rule is followed religiously regardless of the capital market environment.

This second form of rebalancing and the focus of this note we refer to as a constant mix strategy. Constant mix strategies take their cue solely from relative asset price changes over a chosen period of time and seek to bring portfolio weights back to a set of pre-defined time-invariant weights.

Why are many automatic constant mix rebalancing strategies viewed as a free dessert? Constant mix strategies trim relative winners and top up relative losers. Assuming fairly priced asset classes at the beginning of the period a constant mix rebalancing approach can be construed as a value-oriented strategy buying up cheap assets and selling expensive assets.

The working assumption is that capital market forces will correct relative asset class mis-pricings. Under this scenario markets are constantly displaying mean-reverting behavior. Asset classes that go up must come down and vice versa. Kind of a rollercoaster of relative performance.

Rebalancing programs will pick up nickels and dimes by selling relatively expensive assets and investing the proceeds into relatively cheap securities. Transaction costs and short-term capital gain taxes will be incurred but according to proponents of such rebalancing programs, such costs will be offset by gains in portfolio values and as a side benefit – the icing on the cake – a reduction in portfolio risk. Risk in this context is frequently equated with downside volatility as valuation changes are viewed as the primary cause of mean reversion in asset prices.

The idea of buying low and selling high is alluring and under a mean reverting type of market a constant mix strategy would deliver on the promise. But the romantic notion of mean reverting markets often fades away as real capital market behavior with all of its flaws sets in.

Do real capital markets behave in the idealized mean reverting manner necessary for constant mix strategies to shine? Capital markets are ever changing as asset class fundamentals, risk characteristics and investor demand fluctuate for perfectly sensible as well as irrational reasons. Capital markets are constantly calibrating supply and demand conditions and over short-term intervals changes in investor sentiment tend to overpower fundamentals.

There is also a lot of both academic as well as practitioner research on time series momentum. In general the conclusion is that over intermediate time frames such as 12 to 24 months there are trends in asset class performance. Mean reversion as a concept has been thought of more as a 3 to 5 year concept but over the typical time periods used in rebalancing programs (monthly or quarterly) the evidence is more consistent with trends in asset class prices.

Apart from taking advantage of mean reversion patterns in asset class performance how does rebalancing really work? In a recent paper titled Rebalancing Risk, Granger, Greenig, Harvey, Rattray and Zou derive analytical formulas as well as provide empirical evidence on the behavior of constant mix strategies versus an approach that allows asset class weights to drift depending on relative performance.

In the paper they neatly decompose the performance drivers of the constant mix strategy. What they show is that the constant mix strategy can be decomposed as follows:

Constant Mix Portfolio

Buy & Hold Portfolio

Selling Put and Call Options on Relative Asset Performance

The constant mix strategy carries negative convexity meaning that it outperforms when asset class return divergences are small by collecting the premium received for selling the puts and calls on the underlying portfolio.

However, when asset return divergences are large the selling of puts and calls results in losses and the buy and hold portfolio out-performs. In extreme cases when one asset class significantly lags the rest of the portfolio such as in a stock market crash the negative convexity of the strategy can magnify the drawdown.

Another way to think of the constant mix strategy is to put yourself in the shoes of the investor selling puts and calls. When volatility rises holders of the options will benefit and commensurately sellers of options will see an economic loss. That is why the constant mix rebalancing approach is often described as a short volatility strategy.

The authors of Rebalancing Risk conduct a set of empirical and simulation exercises using US stock and bond data. What do they find?

Constant mix portfolios exhibit small positive returns when relative asset class performance (stocks versus bonds in this example) do not perform too differently from each other.
When there are large differences in asset returns the tendency is to exhibit losses relative to buy and hold portfolios. The losses are magnified during periods of extreme relative performance.

The basic prerequisite for constant mix strategies to out-perform buy and hold strategies are reversals in asset class performance. From a risk perspective, constant mix strategies add an element of risk as the approach involves additional option related features. Justifying the use of a constant mix approach by implying risk reduction benefits is theoretically and empirically unfounded.

Access the full report here That Free Rebalancing Dessert Can be Costly!

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Keeping It Real – The Impact of Fees, Taxes and Inflation

What’s more important to investors than real returns?

In a previous note (Leaving Money on the Table) we wrote about the impact of taxes and fees on net strategy returns. Our focus was more conceptual and we highlighted the highly customized nature of after-tax portfolio management advice.

Some of our readers, however, remembered empirical work we had done a number of years back using broad US stock and bond market returns. We decided to update our previous research on the effect of taxes, fees and inflation on the real return to investors.

Our methodology is simple. By necessity we employ some simplifying assumptions regarding fees and taxes. We use S&P 500 and US Government Ten-Year Note returns from the end of 1982 to the end of 2015.

We subtract three levels of “costs” from gross returns:

Management Fees
Taxes (short and long-term)
Purchasing Power (inflation)

The results are eye opening and a timely reminder of the drag on investment returns. A lot of investors would be surprised to see the extent of this drag on their portfolios but in the real world the results may actually turn out to be even worse.

Why? For one many investors pay high fees on their portfolios and ignore the tax efficiency of their strategies.

While not as sexy as a discussion of strategy returns or smart beta minimizing the extent of the cost drag from fees, taxes and loss of purchasing power is an important part of sustained wealth creation

Management fees on portfolios should be scrutinized for value add. Portfolio management has a cost. Index strategies are now available on most market segments in equity and fixed income markets at low cost but the combination of strategies and overall asset allocation still needs to be managed.

Jack Bogle has been talking about the importance of controlling fees for years and investors as a group may have become recently more fee sensitive especially as the realization sinks in that we are most likely going to be living in a low return environment for the next decade.

Paying high fees in a low return environment would certainly impair wealth accumulation targets. Paying fees commensurate with value add should be the goal of investors.

As Benjamin Franklin once said, taxes are as certain as death and as such the best that one can do is minimize the tax bite of investment strategies. Tax loss harvesting, low portfolio turnover, proper strategy selection, and legal deferment of taxable events are elements of a coherent well-designed tax minimization strategy.

Finally, a huge drag on net real returns has been the loss of purchasing power. While inflation in recent years has been below historical norms the loss of purchasing power can best be thought of as an almost invisible downward pull on wealth creation efforts.

Not all investment strategies behave in the same manner in the face of inflationary forces. Properly aligning investment strategies to the expected inflationary environment is an important component of minimizing the deleterious effects of a loss of purchasing power.

If you would like to read our full report please fill out the information below and hit the Send button

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Leaving Money on the Table? Time to Look at Taxes

Thinking about taxes implications for your investments often plays second fiddle in fast moving capital markets and for a large number of investors – pension funds and endowments/foundations the issue is moot given their tax exempt status.

But for many investor be they already wealthy or diligently saving for retirement on their own the issue of taxes is incredibly important. Proper tax management can dramatically alter financial outcomes especially over long periods of time.

Tax management can be complicated and should encompass the full financial and human capital picture and goals of the household or multi-generational family entity. Investments are one aspect of this view but properly evaluating the tax implications of different investment strategies is an important component to the long-term success of an entity’s financial plan.

Taxable investors are not generally able to capture the full potential return of an investment for a number of reasons

The most obvious and frequently discussed reason are fees and expenses
The second and often more significant drag on realized long-term strategy returns is due to taxes

While tax structure and rules vary across geographic domiciles (across countries but also by states ) there are generically speaking two types of taxes that subtract from investor returns – taxes on periodic income received (dividends and coupons) and taxes paid upon the sale of a security.

Measuring the tax bite of an investment strategy depends on individual circumstances but it is still useful to look for generalities to assess the likely impact of different strategies on after-tax portfolio returns

We resort to evaluating four different hypothetical strategies using the theory of tax management as outlined in Chincarini and Kim (Journal of Portfolio Management, Fall 2001).

The wealth path of the four strategies that we evaluate for tax implications are shown to the left.

All strategies assume an annual gross return of 8% and a management fee of 1% per year. The strategies vary by the type of trading incurred.

Main Conclusions:

The advantage of the more tax efficient strategies for creating wealth for investors are clear especially as one extends the holding period. Tax efficient strategies compound at a higher rate because of a smaller proportion of gains paid out as short-term taxes and the deferral of trading events leading to fewer taxable consequences.
Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy. Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant portion of the potential tax alpha on the table.

Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more sophisticated applications encompass security positions across different asset classes. It is also very important to properly account for the intended final disposition of investment assets.

Finally, we would remiss to not point out that tax policy is not only highly specific to geographic areas (say countries and states) but also subject to significant rule changes over time.

If you would like to read our full report please fill out the information below and hit the Send button

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Even A Wide Moat Won’t Save This Brexit

In the weeks leading up to the Brexit referendum vote our assumption was that while the vote would be close the “remain” side would eventually prevail. Our feeling was, I must admit, more based on our observation that under most circumstances electorates prefer to stay with the status quo.

My relatives in the UK had warned me against making such an assumption, but from a pure economic perspective the evidence seemed stacked in favor of remaining within the EU.

Now that we know the outcome of the vote and Brexit has become a reality it downs on me how out of touch we can sometimes be when dealing with unhappy electorates. The evidence is scant for any positive economic benefit for separation from the EU, but the hope for change is sometimes so strong so as to overwhelm rational thought. In my opinion, while the world may have recovered economically from the depths of the 2008 Financial Crisis the seeds of discontent are still alive within large segments of the population.

The rise of nationalism in many countries is tied to the search for simple solutions for promoting adequate growth in the face of weak labor markets and rising income inequality. These simple solutions are often expressed in the form of isolationist strategies with the underlying assumption being that inadequacies in economic growth are caused by outside forces.

But just as building a moat around one’s castle is a totally inadequate way in today’s world to keep outside influences at bay so are policies pretending that world economic forces can be neutralized at one’s door step.

Markets for goods and services today are truly global in nature and while pockets of every economy will remain domestically driven the vast majority of global economic activity takes place in the context of highly competitive supply and demand conditions involving companies frequently conducting business from multiple geographies. Borders don’t matter as much as the ability to offer a value proposition to both producers and consumers.

The 52% of voters in the UK that voted for pulling out of the EU are betting that the UK economy will be better off long-term not being part of the larger economic union. Stifling regulations imposed by the EU are one shackle that UK domiciled companies will no longer have to bear. Another, it is argued, will be removing the burden of subsidizing weaker members of the union.

But while the long-term ramifications of Brexit will not be known in totality for at least a decade or two the shorter-term issues are likely to wreak havoc with investor sentiment. “Risk-off” is likely is to stay with us for a bit longer than expected!

Another Brexit casualty will be sterling denominated assets. Not only will the British Pound depreciate significantly but the demand for UK domiciled stocks and bonds will decrease as well. Sellers will remain highly incentivized so prices will need to drop for buyers and sellers to meet. None of this is rocket science and markets on t+1 are already reflecting these negatives.

While the short-term implications for UK equity owners are negative we do not believe that Brexit will lead to the end of the world. After all our belief is that company fundamentals drive long-term investor rewards and spikes in investor sentiment both positive and negative appear as mere blips in long-term performance charts.

Especially for companies not directly tied to the regulatory consequences of Brexit the news may be good in the short-term as investors express an increased preference for lower uncertainty situations. Even for many UK companies the news does not constitute a death sentence as many already conduct operations in geographically diversified locales. For some export-driven companies the depreciation of the pound will provide short-term competitive advantages.

UK-domiciled assets will not doubt remain under pressure for the foreseeable future. Withdrawing from the EU bloc is fraught with technicalities and will require the negotiation of dozens of trade agreements. Article 50 of the Lisbon Treaty will have to be invoked which will then allow for a two year period of negotiation between the EU and the UK government. Pro-Brexit politicians have openly discussed delaying invoking Article 50 leading to most likely a period of 4 to 5 years of uncertainty. While the Brexit side rejoices today the withdrawal from the EU will not be immediate.

Most times when a political event such as Brexit occurs the size of the overall economic pie does not change materially at least over short and intermediate terms. What tends to happen instead is that the pie gets splits up differently creating losers and winners.

Capital markets are reacting post-referendum as if the size of the pie has permanently shrunk and everybody will go hungry. The reaction of global capital markets would suggest dire consequences for global growth. Risky assets are getting uniformly destroyed and investors are flocking to safe heavens such as the US dollar, long-term US government bonds and precious metals.

Our view is that while global economic growth will experience a hiccup the longer-term effect for global growth will not be significant. For long-term investors with multi-asset class portfolios we do not expect a lasting effect from Brexit but understanding the likely short-term winners and losers could actually yield some very rewarding tactical trades.

In many ways this crisis while most likely painful for the UK economy resembles other periods in history when political events led to a spike in capital market volatility and a rise in investor risk aversion. Such periods were uncomfortable for investors but also yielded tremendous opportunities to add value.

What can we reasonable expect over the next few weeks?

Investor risk aversion will remain elevated as investors seek to understand the long-term implications of Brexit
The US dollar, Swiss Franc and the Yen will strengthen at the expense of the Euro and the British Pound
Commodities apart from precious metals will face downward pressures as the US dollar appreciates. We, however, believe that oil will find its footing reasonable soon as supply/demand conditions seem to be close to equilibrium
Investors will increase the demand for high quality bonds leading to further interest rate decreases. Long duration bonds will benefit the most. Interest rate sensitive assets such as real estate will likewise benefit.
The US Federal Reserve will not raise rates in July and we would be surprised if they institute any hikes this year. The ECB and the Bank of England will cut rates and increase monetary stimulus. Global liquidity will remain plentiful.
Investors with short time horizons will flee risky assets en masse. We should expect outflows from equities to accelerate in the short-term. European and UK portfolios will see the sharpest outflows
Extreme contrarians will advocate buying into UK equities but there will be few takers. We would advocate passing on this trade for now
Contrarians will also advocate buying stocks domiciled in the US. Such a trade won’t require, in our opinion, as long as of a time horizon as buying UK stocks and it will thus entail less risk. Our two top equity tilts remain low valuation and above-average company profitability

In general, we would advocate making only small adjustments to multi-asset class portfolios. The adjustments would be more driven by risk management considerations as we expect asset class volatility to remain elevated for the remainder of 2016. Our risk aversion index (RAI) has also recently moved into the “extreme fear” zone thus calling for a more defensive risk posture.

From a tactical perspective we see opportunities emerging more from bottom-up stock selection activities rather than from sector or country allocation decisions. When whole markets sells off as we saw on the day after Brexit the good gets thrown out with the bad.

In a crisis company fundamentals are often ignored as investors are forced to sell their most liquid holdings first. Market turmoil tends to create attractive entry points for investments with robust long-term fundamentals. We expect global equity markets to remain under pressure next week and we would thus advocate waiting a bit longer to put any excess cash to work.

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Apples to Oranges – The Case Of Commodity Indices

Commodity investing dramatically increased in popularity with both institutions and retail investors in the last decade as it became cheaper and easier to invest in the asset class.

The two primary indices for commodity investing have been the S&P GSCI and the Bloomberg indices. These indices are dramatically different in terms of weighting structure with the S&P GSCI being very energy heavy (63% weight) while the Bloomberg index tends to be more balanced across the primary commodity sectors. As a consequence both indices can have significant performance differences.

Both indices aim to cover the broad spectrum of most actively traded commodities. Commodity pricing is primarily determined by global supply and demand conditions, but that is where the similarities among commodity sub-groups often end.

When investors think of constructing their portfolios usually the starting point are broad asset classes such as stocks and bonds. Asset classes tend to possess fairly well defined risk and return characteristics and represent aggregations of “similar” investment types.

As an example, stocks are usually broken down into economic sectors but most investors would agree that stocks are driven to a large extent by what happens to the broad equity market. Similarly, while fixed income investments are frequently broken down by maturity and credit worthiness, the key driver of fixed income returns tends to be the general direction of government bond rates. In general, return correlations within asset classes such as stocks and bonds tend to be high and frequently exceed 0.8.

When evaluating investment returns within the commodity complex the high within asset class correlations typically seen among stock and bond investments are absent. More common are correlations in the 0.2 to 0.4 range.

The low correlation among commodity groups is a manifestation of a less homogeneous asset grouping than typically seen for other broad asset classes such as equities and bonds. Given that each commodity group has its own supply and demand dynamics and the vastly different swing pricing factors this result is to be expected.

Thinking of commodity investing as a broad concept has been useful for investors as a way to get their feet wet, but given the current depth of commodity markets, the variety of liquid investment vehicles available, and most importantly the dissimilar behavior within the commodity complex we think that looking at the space as one homogeneous asset class is like comparing apples to oranges.

Other sections in this report include:

Thinking of commodity return behavior in terms of risk exposures
What do the risk estimation exposures tell us about commodity sub-group behavior?
What does our research imply for commodities in the context of a multi-asset portfolio?

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Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

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